Rethinking the Lender of Last Resort: Workshop Summary

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: September 2014

Abstract

Lender of last resort (LOLR) is perhaps a central bank’s most controversial role. On the one hand, emergency liquidity assistance to financial institutions is a core responsibility of central banks. This is because of central banks’ unique ability to create liquid assets in the form of central bank reserves, their central position within the payment system and their macroeconomic stabilisation objective. On the other hand, central bank LOLR is seen as very risky; as it potentially creates moral hazard on a massive scale, exposes the central bank to large financial risks, and blurs the boundary with fiscal policy. Moreover, liquidity assistance to individual institutions is typically deeply unpopular, creating reputation risks.

The financial crisis served as a reminder of the critical importance of the LOLR in restoring financial stability. But it also raised fundamental questions about the design of LOLR frameworks and the execution of LOLR policies. How to strike the right balance between limiting risks for central banks and ensuring that the LOLR function can be performed effectively when needed? Should central banks be ambiguous in public about the terms and conditions of liquidity support? Or is there a case for well-articulated LOLR policies, communicated ex ante as part of a broader financial stability framework?

This BIS workshop explored these issues, with a view to providing input into the discussions among central banks, and the public debate more generally. While there was broad agreement that liquidity support during the crisis was key in stabilising the global financial system, the discussions highlighted a number of challenges regarding LOLR policies. These included effective ways of dealing with stigma, questions regarding the design of LOLR policies in a market-based financial system, how to contain moral hazard, and issues of governance of LOLR policies, particularly against the backdrop of evolving financial stability frameworks. Finally, the question of optimal mechanisms for liquidity assistance in foreign currency remains an open one.

The workshop was organised in three sessions plus a working lunch.

The first session, chaired by Hiroshi Nakaso (Bank of Japan), reviewed the experience of major central banks with LOLR measures during the financial crisis. Bill Nelson (Federal Reserve) opened the discussion with an assessment of the Fed’s actions during the crisis. Francesco Papadia (Bruegel) continued the panel with a discussion of how the European Central Bank (ECB) addressed interbank liquidity shortages and wider market dysfunction during the crisis. Andrew Hauser reviewed the Bank of England’s experience during the crisis. José Sidaoui (former Bank of Mexico) provided the perspective of a major emerging market economy (EME), where the foreign exchange market served as a key transmission mechanism of liquidity stress. Hiroshi Nakaso concluded the first session with a review of Bank of 2 BIS Papers No 79 Japan experiences during the 1990s banking crises and new aspects of LOLR action that emerged during the recent financial crisis.

The second session, chaired by Claudio Borio (BIS), discussed how post-crisis changes in the financial system affected the central bank’s role as LOLR. Perry Mehrling (Columbia University) led off with a discussion of new demands on LOLR associated with a market-based credit system. Lex Hoogduin (University of Amsterdam) discussed the relationship between the LOLR and self-insurance against liquidity risk. Morten Bech (BIS) presented several practical proposals for incorporating liquidity insurance through the central bank into bank liquidity regulation. Tim Lane (Bank of Canada) concluded the panel with a short summary of recent and ongoing work on collateral markets in the Committee on the Global Financial System (CGFS).

Sir Paul Tucker (Harvard University) delivered the keynote speech at the working lunch. The speech and the ensuing discussion focused on the issues of LOLR governance.

The third session, chaired by Hyun Song Shin (BIS), focused on the international dimensions of LOLR regimes. Jean-Pierre Landau (Sciences Po) opened the panel discussion with a proposal for a multilateral foreign currency liquidity arrangement that would reduce inefficient accumulation of foreign exchange reserves as a means to provide self-insurance. Giovanni Dell’Ariccia (IMF) discussed the relative merits of self-insurance through foreign exchange reserves, bilateral central bank swap arrangements, multilateral arrangements and IMF credit lines. Michael Dooley (University of California) then discussed the constraints that EME central banks faced in obtaining foreign currency insurance. Finally, Steve Cecchetti (Brandeis University) concluded the panel with a discussion of the implications of the US dollar’s role as a reserve currency for the design of international liquidity support arrangements.

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